Richard Koo: The Real Reason Behind Japanese Market Volatility

Richard Koo of Nomura is out with his latest report. The report discusses in length the reasons for the recent decline and volatility of the Japanese stock market. Richard Koo is skeptical of Abenomics as we pointed out in his late research note in which he stated Japan’s Tactic Of Lying ‘Has Succeeded Brilliantly’. Below is the full report from Richard Koo.

Richard Koo on Japan Market Decline

Stock markets around the world have undergone a correction over the past two weeks, but Japanese equities experienced by far the sharpest hit. The yen also strengthened to some extent against other currencies, signaling a possible end to the trend of a weak yen and a rising stock market.

Reasons cited for the equity selloff include Fed Chairman Ben Bernanke’s remarks about ending quantitative easing and a weaker than expected (preliminary) Chinese PMI reading from HSBC Holdings plc (NYSE:HBC) (LON:HSBA) on 23 May. However, I think a more fundamental factor was also involved: stocks had risen far above the level justified by improvements in the real economy. The yen’s decline and the stock market gains that followed the announcement of Abenomics at the end of last year clearly outpaced the economic recovery.

The prevailing view is that we are finally seeing a reaction to this excessively rapid move, and if so this is a healthy correction. The reality, however, may be somewhat more complicated.

More specifically, the sharp rise in equities that lasted from late in 2012 until a few weeks ago and the several virtuous cycles that fueled this trend were themselves made possible by a special set of circumstances.

Whereas overseas investors responded to Abenomics by selling the yen and buying Japanese stocks, Japanese institutional investors initially refused to join in, choosing instead to stay in the bond market.

Because of that decision, long-term interest rates did not rise. That reassured investors inside and outside Japan who were selling the yen and buying Japanese equities, giving added impetus to the trend.

The next question is why domestic and overseas investors responded so differently to Abenomics. One answer is that many domestic institutional investors understood that private-sector borrowing in Japan is negligible in spite of zero interest rates and that there was no reason why monetary accommodation—including the BOJ’s quantitative easing policies—should be effective.

Short-term rates in Japan have been at or near zero since around 1995, some 18 years ago. The BOJ engaged in an aggressive quantitative easing initiative from 2001 to 2006, under which it supplied more than ¥30trn in excess reserves at a time when statutory reserves amounted to just ¥5trn. Yet neither the economy nor asset prices reacted meaningfully.

In the last few years, Japanese corporate balance sheets have grown much healthier and interest rates have remained at historic lows. Yet private demand for funds did not recover because 1) firms were still in the grip of a debt trauma and 2) there was a shortage of domestic investment opportunities.

Japan’s institutional investors were painfully aware of this reality, which had left them facing a lack of domestic investment opportunities for more than a decade. From their perspective, there was no reason to expect another foray into quantitative easing by the BOJ under pressure from the Abe administration to lift the economy, and therefore no reason to change their behavior.

Richard Koo: But overseas investors bet on bold monetary easing

Meanwhile, overseas—and particularly US—hedge funds that had been betting on a worsening of the euro crisis until last autumn were ultimately unable to profit from those positions because the euro did not collapse.

Then in late last year, the Abe government announced that aggressive monetary accommodation would be one of the pillars of its three-pronged economic policy. Overseas investors responded by closing out their positions in the euro and redeploying those funds in Japan, where they drove the yen lower and pushed stocks higher.

I suspect that only a handful of the overseas investors who led this shift from the euro into the yen understood there was no reason why quantitative easing should work when private demand for funds was negligible. Had they understood this, they would not have behaved in the way they did.

Richard Koo: Bond and equity markets took very different views of Japan’s economy

The yen weakness and stock market appreciation brought about by this money began to buoy sentiment within Japan, paving the way for further gains in equities. They also prompted retail investors to enter the market, providing more fuel for the virtuous cycle.

Japanese equities were up 80% from their lows at one point. However, this virtuous cycle was based on the key assumption that interest rates—and long-term interest rates in particular—would not rise.

This condition was satisfied as long as domestic institutional investors remained in the JGB market, but consequently the views of the Japanese economy held by equity and bond market participants diverged substantially.

Moreover, even though the moves in the equity and forex markets were led by overseas investors with little knowledge of Japan, the resulting improvement in sentiment and the extensive media coverage of inflation prospects forced domestic institutional investors to begin selling their bonds as a hedge.

Richard Koo: Honeymoon for Abenomics finally ends

The result was a correction in the JGB market from mid-April onwards, with the ensuing turmoil prompting a correction in equities as well.

In that sense, the period from late last year until mid-April was a honeymoon for Abenomics in which everything that could go right, did. However, the honeymoon was based on the assumption that the bond market would remain firm. The recent upheaval in the JGB market signals an end to the virtuous cycle that pushed stock prices steadily higher. This means further gains in equities will require stronger corporate earnings and a recovery in the economy.

Richard Koo: Yen weakness likely to persist on trade deficits

The share price increases driven by the prospect of improved corporate earnings due to the weaker yen will probably persist going forward. Now that Japan is running trade deficits, the yen is unlikely to see the kind of appreciation observed in the past.

Naturally, exchange rates are relative things, and the yen might well rise back into the 90–100 range against the US dollar depending on conditions in the US economy. But I do not expect USD/JPY to return to the area below the mid-80s.

The yen’s decline to around 100 against USD has definitely been a positive for the Japanese economy. But authorities will need to tread carefully when dealing with additional yen weakness, including the question of what might stop the yen from falling further. Excessive drops in the currency could spark a “sell Japan” movement like that seen in 1997, when investors simultaneously sold off the yen, Japanese stocks, and Japanese bonds.

In addition, the cheap imports represented by the proliferation of so-called ¥100 shops have played an important role in maintaining the living standards of ordinary Japanese consumers at a time of sluggish or falling incomes. Further declines in the yen might benefit a handful of exporters but could also lower living standards for the majority of people.

Richard Koo: Virtuous cycle for Abenomics has reached turning point

Now that USD/JPY has fallen to what I see as a comfortable level and the Japanese bond market has broken its silence, I think the virtuous cycle for Abenomics in evidence since late last year is at a critical juncture.

That is not to say that current exchange rates or long-term bond yields are cause for concern. Compared to where they were before, current levels are both reasonable and comfortable.

But from this point on, the environment will be very different in the sense that there will be greater emphasis on 1) consistency between the bond and stock markets and 2) the negative implications of a weaker currency.

The Bank of Japan began buying longer-term JGBs on 4 April with the goal of pushing yields down across the curve. The outcome of those purchases, however, has been exactly the opposite of what Governor Haruhiko Kuroda intended, with long-term bond yields moving higher in response.

Domestic mortgage rates have increased for two consecutive months as a result. This is clearly an unfavorable rise in rates driven by concerns of inflation, as opposed to a favorable rise prompted by a recovery in the real economy and progress in achieving full employment.

The more the market senses the BOJ’s determination to generate inflation at any cost, the more interest rates—and particularly longer-term rates—will rise, adversely impacting not only Japan’s economy but also the financial positions of banks and the government.

Richard Koo: Recovery can offset many negatives of rising rates

As I also noted in my last report, a recovery-driven rise in rates occurs when the economy rebounds and approaches full employment, fueling concerns about inflation and pushing interest rates higher.

Because the economy is in recovery, banks are lending more to the private sector and government tax revenues are expanding. Even if higher interest rates cause losses on banks’ bond portfolios or increase the cost of borrowing for the government, there is sufficient offsetting income.

In other words, the government and banks are both capable of absorbing significant increases in interest rates as long as the economy is in recovery.

However, today’s BOJ is recklessly easing monetary policy to generate inflation expectations in the hope that those expectations will spark a recovery in the real economy. In this case, inflation expectations precede the recovery, creating the risk that rates will rise before the economy picks up.

Since there is no increase in bank earnings from additional lending activity and no increase in tax revenues from a recovering economy, the financial positions of banks and the government deteriorate in direct proportion to the rise in long-term interest rates.

The resulting shrinkage of equity capital constrains banks’ ability to lend, while the government is forced to cut spending or increase taxes. Both of these outcomes will naturally weigh on the economy.

Of special concern is the risk that a rise in rates prior to a pick-up in private loan demand will force the government to engage in fiscal consolidation. The economy could quickly sink if the government stops borrowing and spending at a time when there are no private-sector borrowers.

In this regard, it was shocking to note that BOJ Governor Kuroda, senior IMF official David Lipton, and even a handful of private-sector economists in Japan have over the last two weeks urged the government to engage in fiscal retrenchment to prevent a further rise in interest rates.

I would have no objection if they were making the argument because they had proof that private demand for funds was about to increase substantially. But without such evidence, they risk sending Japan’s economy back into the abyss.

If private demand for funds were actually on the rebound, the private sector would be able to borrow and spend the unborrowed private savings that have weighed on Japan’s economy for the last 20 years without any need for fiscal stimulus. That, in turn, would free up the government to put its finances in order and in fact would mean it was time for it to do so. But fiscal consolidation in any other circumstances could lead to a repetition of the Hashimoto government’s failed experiment in 1997.

Unfortunately, the lack of data for the period since Mr. Kuroda’s policies began makes it difficult to draw any certain conclusions at this time.

It should be noted that the sharp rise in share prices has refocused attention on the real estate market, prompting some investors and individuals to buy property now before inflation sends prices higher. Although the resulting demand for loans does increase the demand for funds, transactions like these that merely involve a transfer of ownership do little to resolve the problem of unborrowed savings that is at the heart of Japan’s economic malaise.

A transfer of ownership only shifts savings around within the financial system—the buyer’s deposits decrease and the seller’s deposits increase, but the savings remain within the financial system.

The money must be used for consumption or investment in order for the problem of unborrowed savings to be resolved.

Richard Koo: But increased investment does

In addition to new demand for loans, the deployment of businesses’ retained earnings for new investments can also reduce unborrowed savings, since any reduction in retained earnings represents a decline in unborrowed savings languishing somewhere at financial institutions.

Increased investment demand therefore reduces the need for the government to borrow and spend, enabling it to pursue fiscal consolidation without adversely affecting the economy. In this regard, the claim in the 3 June issue of the Nikkei that large Japanese enterprises plan to invest 12.3% more in FY13 than they did in FY12 is a welcome development. This probably includes export-related firms and companies competing with imports that have decided to ramp up domestic production for the first time in many years in response to the weak yen.

Richard Koo: “Bad” rise in rates renders two of three pillars of Abenomics powerless

We cannot be too complacent, however, because the size of the surplus private savings problem in Japan is huge. At the moment we only have data through 2012 Q4, and they show that private sector savings amounted to a seasonally adjusted 7.11% of GDP in spite of zero interest rates. This means the public sector must be borrowing and spending a comparable amount in order to keep the economy going.

If the level of savings is largely unchanged today, Japan’s economy could easily stall if the government were to stop borrowing and spending the private sector savings surplus.

The second pillar of Abenomics—fiscal stimulus—was put in precisely to address this risk. If an unfavorable rise in interest rates not only prevented the government from borrowing and spending but actually forced it to raise taxes and cut back on expenditures, that would be putting the cart before the horse.

It would effectively mean that an excessive reliance on the first pillar—monetary accommodation—had prompted an unfavorable rise in rates, forcing the government to abandon the second pillar, which is essential when the private sector is saving so much at zero interest rates.

Richard Koo: “Bad” rise in rates should be addressed with adjustments to monetary policy

In this regard, we need to watch out for the possibility of an increase in long-term rates driven by mounting inflation concerns without a recovery in private demand for funds. If, for example, people see inflation picking up before long—even if there is no inflation today—they will no longer be willing to hold 10-year government bonds yielding less than 1%. If they decide to convert their JGBs to cash and buy them back once prices have fallen, long-term rates will rise sharply. This kind of selling is already being observed in some quarters.

When facing this kind of unfavorable rise in rates fueled only by inflation concerns and not by a recovery in private demand for funds, the government should respond not with fiscal consolidation but rather with adjustments to the BOJ’s overly accommodative monetary policy.

If the BOJ refused to modify its policy and forced the government to engage in fiscal retrenchment, the Japanese economy will suffer badly given the weakness of private demand for funds.

On the other hand, when interest rates are rising because of a recovery in private demand for funds, the proper response for the government is to raise taxes and cut spending in order to keep upward pressure on interest rates in check.

If the Japanese economy were actually in such a phase, the economy could probably continue making progress even after the consumption tax is hiked next April.

Richard Koo: Unfavorable rise in rates must be dealt with carefully

Then-BOJ Governor Toshihiko Fukui, who understood all of this, said in 2005 that there was no problem with fiscal consolidation as long as its scale was consistent with the recovery in private demand for funds (see my report dated 8 March 2005 for details). But the officials now making a case for fiscal consolidation—Mr. Kuroda, Mr. Lipton, and private economists—give no sense of having confirmed that private demand for funds is actually picking up.

The implication is that they may respond to an unfavorable rise in rates by scaling back fiscal expenditures instead of making adjustments to monetary policy. We need to watch out for this risk very closely.

Only 22% of people surveyed by the Nikkei felt Japan’s economy is actually recovering (27 May 2013), suggesting relatively few have benefited from Abenomics’ honeymoon thus far.

Moreover, an increase in long-term rates at a time when 78% of the population is not personally experiencing a recovery is most likely a “bad” rise in rates, and the authorities need to address it very carefully, keeping a close eye on private demand for funds.

Richard Koo: Signs of major changes in Europe

Turning our attention to Europe, there have been a number of signs of a major shift in direction in the last two weeks. Although it remains to be seen whether this is just preelection noise or actually the beginning of a significant development, we need to pay close attention going forward.

First was an article in German weekly Der Spiegel noting that German Finance Minister Wolfgang Schäuble is considering abandoning his focus on fiscal consolidation and enabling government-owned development bank KfW (“Reconstruction Credit Institute”) to provide direct funding to private companies in Spain and elsewhere (an English translation of the article, “Austerity About-Face: German Government to Gamble on Stimulus” can be found at http://www.spiegel.de/international/europe/germangovernment- to-test-stimulus-instead-of-austerity-a-901946.html).

Specifically, the plan would have KfW step in for Spanish banks—which are experiencing difficulty in lending because of balance sheet damage incurred following the collapse in housing prices—and provide low-interest loans funded by the credit of the German government to Spanish businesses via financial institutions affiliated with the Spanish
government.

Although Spanish government bond yields have fallen from their peaks, the spread with German government debt remains at nearly 300bp. Distressed Spanish banks continue to have difficulty obtaining funding and must take a very cautious approach to lending. Even those Spanish banks that are able to lend money need to charge high rates of interest.

In contrast, German government bond yields—while up somewhat from their lows— remain at the historically low level of about 1.5%. If KfW can lend money to Spanish businesses at this rate plus a reasonable spread, it would provide a major boost to Spanish companies forced to deal with a largely dysfunctional financial sector.

Richard Koo: And also address problem of capital flight

This plan would also provide a way to return to Spain the private savings that have fled to Germany during Spain’s balance sheet recession. If implemented, Mr. Schäuble’s plan would be the first effort of its kind to address the capital flight problem that is specific to the eurozone where multiple government bond markets exist within the same currency
zone.

One of the reasons for the economic weakness in the eurozone is that the German public and private sectors have not borrowed and spent the private savings that have flowed in from Spain and other countries experiencing balance sheet recessions, resulting in an increase in unborrowed savings across the eurozone. Under the proposed plan, KfW would borrow these savings and return them to Spain, where they are actually needed, thereby reducing the zone-wide unborrowed savings and stimulating the eurozone’s economy.

The Spiegel article says related legislation would have to be revised to enable KfW to engage in such lending, and Mr. Schäuble has apparently sent a letter discussing this scheme to Philipp Rösler, leader of coalition partner FDP (“Free Democratic Party”).

A third encouraging sign is the fact that the EU itself is reconsidering the tough fiscal demands placed on member countries and has agreed to extend by 1–2 years the deadline for five countries, including France and Spain, to achieve deficit-reduction
targets.

Until now the EU—perhaps because of Germany’s influence—has taken an extremely rigid stance on the targets, even hinting at the possibility of penalties for countries that are late in meeting them. But now it has agreed to extend the deadline, citing unexpected difficulties.

Behind the change of heart is the fact that the EU’s forecast that the economy would improve if countries simply engaged in fiscal consolidation and other structural reforms turned out to be completely wrong. Eurozone unemployment rates continue to set new highs. And economies have continued to weaken even though many countries have carried out substantial reforms and scaled back fiscal expenditures.

That the EU’s economic forecast has been so wrong for so long indicates the economy envisioned by the EU is very different from the actual economy. I suspect that recognition has forced the EU to modify its stance.

Richard Koo: But policy shift at EU not based on true understanding of problem

While this change in stance by the German finance minister and the EU should be welcomed, I do not believe it is based on a solid understanding of the eurozone’s economic problems.

Related documents and statements by Mr. Schäuble and the EU offer no analysis or reflection on the reasons why their policies failed to produce the expected results. Without such analysis and reflection, there is no guarantee the new method of treatment will be appropriate for the patient.

So what did they get wrong? Essentially, they interpreted the economic slump as being driven by structural problems when it was actually the result of balance sheet problems.

tructural and balance sheet problems are similar in that they are both difficult to address with ordinary monetary policy and fiscal policy. However, while there was a great deal of discussion regarding structural problems starting with the era of Reagan and Thatcher some 30 years ago, balance sheet problems have not even been recognized by economists outside Japan until quite recently.

Japan made the same mistake during the Koizumi era. In spite of all the time spent debating the merits of the privatization of highway agencies and the postal service, the economy did not improve when they were eventually privatized.

Moreover, the authorities in Japan then—not unlike those in the eurozone today—were oblivious to the dangers posed by business and households increasing savings at a time of zero interest rates in order to clean up their balance sheets.

Richard Koo: Structural problems very different from balance sheet problems

Structural problems are an entirely different creature from balance sheet problems. They must be addressed with labor market reforms and other microeconomic policies, whereas balance sheet problems require plenty of fiscal stimulus and time.

Moreover, an economy facing balance sheet problems can quickly spiral downward unless the government is quick to administer fiscal stimulus in order to borrow and spend the private sector’s unborrowed savings. Structural problems, on the other hand, cause the economy to weaken slowly and over an extended period of time as it gradually loses competitiveness and its vitality.

Many countries in the west are currently experiencing both types of problems. In such cases, the authorities need to deal with balance sheet problems first for the reasons noted above and only then address the structural issues. Reversing this order can have tragic results.

Richard Koo: Time will be needed for Europeans to feel positive changes for themselves

That Mr. Schäuble and the EU are moving away from their disastrous demands for fiscal retrenchment in countries facing balance sheet recessions should be welcomed. However, news reports suggest they still do not understand the full essence of the problem or the need to address balance sheet problems first.

Moreover, a modest relaxation of fiscal demands will not be enough to overcome the scale of balance sheet problems of eurozone countries. In Q4 2012, for example, Spain’s private sector was saving at a seasonally adjusted rate of 15.57% of GDP. Returning this massive unborrowed savings to the income flow in the Spanish economy will require a similarly large fiscal stimulus.

While recent policy developments in the eurozone represent a move in the right direction, they are not based on adequate analysis or reflection and remain entirely inadequate.

To conclude, eurozone policymakers appear finally to be moving in the right direction, but it will take time before these measures reach the necessary scale and people are able to feel the results for themselves.